Capital Budgeting

Introduction
A beer company is considering building a new brewery.
 An airline is deciding whether to add flights to its schedule.
 An engineer at a high-tech company has designed a new microchip
and hopes to encourage the company to manufacture and sell it.
 A small college contemplates buying a new photocopy machine.
 A nonprofit museum is toying with the idea of installing an education
center for children.
 Newlyweds dream of buying a house.
 A retailer considers building a Web site and selling on the Internet.
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Introduction
 What do these projects have in common? All of them entail a
commitment of capital and managerial effort that may or may
not be justified by later performance.
 A common set of tools can be applied to assess these
seemingly very different propositions.
 The financial analysis used to assess such projects is known as
“capital budgeting.”
 How should a limited supply of capital and managerial talent be
allocated among an unlimited number of possible projects and
corporate initiatives?
 Capital Budget

 Capital budget is the budget of capital expenditures.

 Capital Expenditures are those expenditures whose benefit
spread in number of years e.g., purchase of Plant and
Machinery , Land and building and starting a new factory
plant etc.
 Capital budgeting: is the planning process for allocating all
expenditures that will have an expected benefit to the firm for
more than one year.
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Capital Budgeting
 Capital budgeting is the process of identifying,
evaluating, planning, and financing an organization’s
major investment projects.
 Decisions to expand production facilities, acquire new
production machinery, buy a new computer, or
remodel the office building are all examples of capital-
expenditure decisions.
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Capital Budgeting
 Capital-budgeting decisions made now determine to a large
degree how successful an organization will be in achieving its
goals and objectives in the years ahead.
 Capital budgeting plays an important role in the long-range
success of many organizations because of several characteristics
that differentiate it from most other elements of the master budget.
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BASIC FEATURES OF CAPITAL BUDGETING

 Capital budgeting decisions have long-term implications.

 These decisions involve substantial commitment of funds.
 These decisions are irreversible and require analysis of minute
details.
 These decisions determine and affect the future growth of the firm.
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Capital Budgeting
 Capital budgeting projects require relatively large commitments of
resources. Major projects, such as plant expansion or equipment
replacement, may involve resource outlays in excess of annual net
income.
 Relatively insignificant purchases are not treated as capital
budgeting projects even if the items purchased have long lives. For
example, the purchase of 100 calculators at $15 each for use in the
office would be treated as a period expense
 by most firms, even though the calculators may have a useful life of
several years.
 9

Capital Budgeting
 Most capital expenditure decisions are long-term commitments.
 The projects last more than 1 year, with many extending over 5,
10, or even 20 years.
 The longer the life of the project, the more difficult it is to predict
revenues, expenses, and cost savings.
 Capital-budgeting decisions are long-term policy decisions and
should reflect clearly an organization’s policies on growth,
marketing, industry share, social responsibility, and other goals
 Investment Appraisal
 Firms normally place projects in the following categories:
• Replacement and maintenance of old or damaged equipment.
• Investments to upgrade or replace existing equipment
• Marketing investments to expand product lines or distribution
facilities.
• Investments for complying with government
 OVERALL AIM
 To maximise shareholders wealth..
 Projects should give a return over and above the marginal
weighted average cost of capital.

Projects can be;

 Mutually exclusive
 Independent
 IDEAL SELECTION METHOD
• Select the project that maximises shareholders wealth

• Consider all cash flows

• Discount the cash flows at the appropriate market

determined opportunity cost of capital
Need for Investment Appraisal

• Large amount of resources are involved and wrong decisions

could be costly
• Difficult and expensive to reverse
• Investment decisions can have a direct impact on the ability
of the organisation to meet its objectives
Investment Appraisal Process
 Stages:
• identify objectives. What is it? Within the corporate
objectives?
• Identify alternatives.
• Collect and analyse data. Examine the technical and
economic feasibility of the project, cash flows etc.
Investment Appraisal Process
 Stages:
• decide which one to undertake
• authorisation and implementation
• review and monitor: learn from its experience and try to
improve future decision - making
Capital Budgeting - Methods

 1. Accounting Rate of return

 2. Payback

 3. Net Present Value

 4. Internal Rate of Return

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2. DECISION CRITERIA
TECHNIQUES OF EVALUATION

Traditional or Time-adjusted or
Non-discounting Discounted cash flows

1. Payback period 1. Net Present Value

2. Accounting Rate of 2. Profitability Index
Return 3. Internal Rate of Return
Accounting Rate of Return (ARR)
Accounting Rate of Return method relates average annual profit to either the amount
initially invested or the average investment, as a percentage.
Formulae:
ARR = Average annual accounting profit x 100
Average investment
Where:
 Average annual profit = Total profit/Number of years
 Average investment = (initial capital investment + scrap value) / 2
Accounting Rate of Return (ARR)

ARR = Avg. Net Income Per Year

Avg. Investment
Average Return on Investment

 Example:
 Year Net Income Cost
1 6,000 100,000 Initial
2 8,000 0 Salvage
Value
3 11,000
4 13,000
5 16,000
6 18,000
Average Return on Investment

 Avg. Net Income 72,000

= 12,000
 6

 Avg. Investment 100,000

= 50,000
 2

 AROI 12,000
= 24%
 50,000
Average Return on Investment

 Advantages

 Disadvantages
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Proposed Project

Bibba is evaluating a new project for her firm,

Bibba Bakery (BB).
 She has determined that the after-tax cash
flows for the project will be $10,000; $12,000;
$15,000; $10,000; and $7,000, respectively, for
each of the Years 1 through 5. The initial cash
outlay will be $40,000.
 24

TRADITIONAL OR NON-DISCOUNTING
TECHNIQUES

I . PAYBACK PERIOD:
# The payback period is defined as “the number of years
required for the proposal’s cumulative cash inflows to be equal to its
cash outflows.”
# The payback period is the length of time required to recover
the initial cost of the project.
# The payback period may be suitable if the firm has limited
funds available and has no ability or willingness to raise additional
funds.
 Payback Period (PBP)
-40 K 10 K 12 K 15 K 10 K 7K

0 1 2 3 4 5
PBP is the period of time required for the cumulative
expected cash flows from an investment project to equal
the initial cash outflow.
 Payback Solution (#1)
0 1 2 3 4 5

-40 K (b) 10 K 12 K 15 K 10 K 7K (d)

10 K 22 K 37 K 47(c)
K 54 K

Cumulative
Inflows PBP = a + ( b - c ) / d = 3 + (40 - 37)
/ 10 = 3 + (3) / 10
= 3.3 Years
 Payback Solution (#2)
0 1 2 3 4 5

-40 K 10 K 12 K 15 K 10 K 7K
-40 K -30 K -18 K -3 K 7K 14 K

PBP = 3 + ( 3K ) / 10K =
Cumulative 3.3 Years
Cash Flows Note: Take absolute value of last negative cumulative cash
flow value.
 PBP Acceptance Criterion
The management of Basket Wonders has set a
maximum PBP of 3.5 years for projects of this
type.
Should this project be accepted?

Yes! The firm will receive back the initial cash outlay
in less than 3.5 years. [3.3 Years < 3.5 Year Max.]
 PBP Strengths
and Weaknesses
Strengths: Weaknesses:
 Easy to use and  Does not account
understand for TVM
 Can be used as a  Does not consider
measure of liquidity cash flows beyond the PBP
 Easier to forecast ST
than LT flows  Cutoff period is
subjective
 30
ACCOUNTING RATE OF RETURN (OR) AVERAGE
RATE OF RETURN (ARR)
# The ARR may be defined as “the annualized net income earned on the
average funds invested in a project.”
# The annual returns of a project are expressed as a percentage of the net
investment in the project.

COMPUTATION OF ARR:

Average Annual profit (after tax)

ARR = x 100
Average Investment in the Project
INTERNAL RATE OF RETURN (IRR) METHOD:
31

 The IRR of a proposal is defined as the discount rate which produces a zero NPV, i.e.,
the IRR is the discount rate which will equate the present value of cash inflows with the
present value of cash outflows.

 The IRR is also known as Marginal Rate of Return or Time Adjusted Rate of
Return.

 The time-schedule of occurrence of future cash flows is known but the rate of
discount is not.

 The discount rate calculated will equate the present value of cash inflows with the
present value of cash outflows.
---------------------
 Internal Rate of Return (IRR)
IRR is the discount rate that equates the present value of the future net cash
flows from an investment project with the project’s initial cash outflow.
The discount rate also refers to the interest rate used in discounted cash flow
(DCF) analysis to determine the present value of future cash flows.

CF1 CF2 CFn

ICO = + +...+
(1+IRR)1 (1+IRR)2 (1+IRR)n
 IRR Solution (Try 10%)
$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) +$15,000(PVIF10%,3) +
$10,000(PVIF10%,4) + $ 7,000(PVIF10%,5)
$40,000 = $10,000(.909) + $12,000(.826) + $15,000(.751) + $10,000(.683) +
$ 7,000(.621)
$40,000 = $9,090 + $9,912 + $11,265 + $6,830 + $4,347
= $41,444 [Rate is too low!!]
 IRR Solution (Try 15%)
$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) +
$15,000(PVIF15%,3) + $10,000(PVIF15%,4) + $ 7,000(PVIF15%,5)
$40,000 = $10,000(.870) + $12,000(.756) + $15,000(.658) +
$10,000(.572) + $ 7,000(.497)
$40,000 = $8,700 + $9,072 + $9,870 + $5,720 +
$3,479 = $36,841 [Rate is too
high!!]
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Capital Budgeting
1 40000 10000 1.1 9091 1.2 8696
2 12000 1.2 9917 1.3 9074
3 15000 1.3 11270 1.5 9863
4 10000 1.5 6830 1.7 5718
5 7000 1.6 4346 2 3480
41455 36830

IRR has to be increased IRR has to be lowered

 IRR Solution (Interpolate)
.10 $41,444
.05 X IRR $40,000 $1,444
$4,603
.15 $36,841

($1,444)(0.05) $4,603

X= X = .0157

IRR = .10 + .0157 = .1157 or 11.57%

 IRR Acceptance Criterion
The management of Basket Wonders has
determined that the hurdle rate is 13% for projects
of this type.
Should this project be accepted?

No! The firm will receive 11.57% for each dollar

invested in this project at a cost of 13%. [ IRR <
Hurdle Rate ]
 IRR Solution

$40,000 = $10,000 $12,000

+ +
(1+IRR)1 (1+IRR)2
$15,000 $10,000 $7,000
+ +
(1+IRR)3 (1+IRR)4 (1+IRR)5

Find the interest rate (IRR) that causes the discounted

cash flows to equal $40,000.
 39

Net Present Value (NPV)

 (NPV) is the difference between the setup cost of a project and the
value of the project once it is set up.
 If that difference is positive, then the NPV is positive and the project
creates wealth.
 If a firm must choose from several proposed projects, the one with
the highest NPV will create the most wealth, and so it should be the
one adopted.
 40

NET PRESENT VALUE (NPV) METHOD:

 The NPV of an investment proposal may be defined as the sum of
the present values of all the cash inflows less the sum of present
values of all the cash outflows associated with the proposal.
 The decision rule is “ Accept the proposal if its NPV is positive and
reject the proposal if the NPV is negative”.
 Net Present Value
 For example, suppose the car company can either build the new plant
or, alternatively, can introduce a new product— a mid segment car.
 There is not enough managerial talent to oversee more than one new
project, or maybe there are not enough funds to start both.
 Let us assume that both projects create wealth:
 The NPV of the new plant is $1 million, and the NPV of the new-product
project is $500,000.
 If it could, the car company should undertake both projects; but since it
has to choose, building the new plant would be the right option
because it has the higher NPV.
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PROFITABILITY INDEX METHOD:

This technique is a variant of the NPV technique and is also known as BENEFIT -
COST RATIO or PRESENT VALUE INDEX.

Total present value of cash inflows

PI = Total present value of cash outflows.

Accept the project if its PI is more than 1 and reject the proposal if
the PI is less than 1.
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CAPITAL BUDGETING PRACTICES IN INDIA

• Capital budgeting decisions are undertaken at the top management level and are planned in
advance.
• Discounted cash flow techniques are more popular now.
• High growth firms use IRR more frequently whereas Payback period is more widely used by
small firms.
• PI technique is used more by public sector units than by private sector units.
Capital budgeting decisions are of paramount importance as they affect the profitability of
a firm, and are the major determinants of its efficiency and competing power.
 44

ADVANTAGES AND DISADVANTAGES OF IRR AND NPV

A number of surveys have shown that, in practice, the IRR
method is more popular than the NPV approach.
 The reason may be that the IRR is straightforward, but it uses
cash flows and recognizes the time value of money, like the
NPV.
 In other words, while the IRR method is easy and
understandable, it does not have the drawbacks of the ARR
and the payback period, both of which ignore the time
value of money.

 45

ADVANTAGES AND DISADVANTAGES OF IRR AND

NPV
 The main problem with the IRR method is that it often gives
unrealistic rates of return.
 Suppose the cutoff rate is 11% and the IRR is calculated as
40%. Does this mean that the management should
immediately accept the project because its IRR is 40%.
 The answer is no! An IRR of 40% assumes that a firm has
the opportunity to reinvest future cash flows at 40%. If past
experience and the economy indicate that 40% is an
unrealistic rate for future reinvestments, an IRR of 40% is
suspect.
 46

WHY THE NPV AND IRR SOMETIMES SELECT

DIFFERENT PROJECTS
 When comparing two projects, the use of the NPV and the IRR
methods may give different results. A project selected
according to the NPV may be rejected if the IRR method is
used.
 Suppose there are two alternative projects, X and Y. The
initial investment in each project is $2,500. Project X will
provide annual cash flows of $500 for the next 10 years.
Project Y has annual cash flows of $100, $200, $300, $400,
$500, $600, $700, $800, $900, and $1,000 in the same period.
WHY THE NPV AND IRR SOMETIMES SELECT
DIFFERENT PROJECTS
 Using the trial and error method you find that the IRR of
Project X is 17% and the IRR of Project Y is around 13%.
 If you use the IRR, Project X should be preferred because
its IRR is 4% more than the IRR of Project Y.
 But what happens to your decision if the NPV method is
used?
 The answer is that the decision will change depending on
the discount rate you use.

47
 48

WHY THE NPV AND IRR SOMETIMES SELECT

DIFFERENT PROJECTS
 For instance, at a 5% discount rate, Project Y has a higher
NPV than X does. But at a discount rate of 8%, Project X is
preferred because of a higher NPV.
 The purpose of this numerical example is to illustrate an
important distinction: The use of the IRR always leads to the
selection of the same project, whereas project selection
using the NPV method depends on the discount rate
chosen.
49
 1 Gross Profit Margin = Gross profit / Sales X 100

= 2,00,000 /5,00,000 X 100

= 40%

2. Expenses Ratio = Op. Expenses / Net Sales X 100

1,13,000 / 5,00,000 X 100

= 22.60%

3 Operating Ratio = Cost of goods sold + Op.Expenses /

Net Sales X 100

= 3,00,000 + 1,13,000 / 5,00,000 X 100

= 82.60%

Cost of Goods sold = Op. stock + purchases + carriage and

Freight + wages – Closing Stock = 76250 + 315250 + 2000 +
5000 ‐ 98500 = Rs.3,00,000
 4. Net Profit Ratio = Net Profit/ Net Sales X 100
= 84,000/ 5,00,000 X 100
= 16.8%

5. Operating Profit Ratio = Op. Profit /Net Sales X 100

Operating Profit = Sales – COGS - Op. Exp.
= 87,000 /5,00,000 X 100
= 17.40%

6. Stock Turnover Ratio = Cost of goods sold/ Avg.

Stock
= 3,00,000/ 87,375 = 3.43 times